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GLOBAL EXPERIENCE, PRACTICAL EXPERTISE
A PRACTICAL APPROACH FOR BANKS ON HOW
TO LIMIT COST OF NON-PERFORMING LOANS
PREVENTING & RESOLVING
If you make loans, you will have Problem Loans: while no lender intends to make a
Problem Loan, lending institutions (should) anticipate having some level of Problem Loans
and loan losses. Problem Loans are simply a by-product of the business of lending.
It boils down to cash flow: while there are different strategies for managing and resolving
corporate and retail Problem Loans, the underlying problem is the same – a lack of cash
flow to pay their creditors and costs
Resolving problems is expensive and difficult: managing Problem Loans properly is a
complex, time-consuming task, which frequently requires specialized knowledge and
expertise in, credit analysis, bankruptcy and security laws, as well as negotiating.
The objective: The overriding objective in managing Problem Loans is to enhance or
improve the position of the lending institution.
Goal of Problem Loan Management is to
obtain maximum recovery in minimum time
Credit Policies: Issued by the Board of Directors. Credit Policies are detailed statements
designed to guide and control the direction and activities of the lending function. They
are standardised to prevent as far as possible potentially problematic lending.
Risk Rating System: This helps quantify the inherent risk of lending either to a
borrower, or within a loan portfolio. A systemic Risk Rating System attempts to measure
the probability that a borrower will be able to repay both principal and interest as agreed.
Independent Risk Management Division: There has to be body within the bank that looks
at every risk from the point of view of the bank and not the customer. The customer is not
always “king” in a bank. Risk Management second guess lending and treasury divisions
Lending authorities: A key decision for every Board of Directors is the allocation of
decision making authority, how much, to whom and what checks on their authority.
Review system: Every risk must be reviewed at least once a year as if it is a new
facility, even if it is a term loan.
RULE 1: PREVENTION IS ALWAYS
CHEAPER THAN CURE
To identify, monitor and manage problem loans they must first be found.
Early detection of a looming problem is central to an institution's ability to defend against
and limit the impact of Non –Performing Loans. Institutions should not rely solely on
lagging indicators, such as past due payments, which as it is much later in the process
leaves the lender with fewer options to correct the situation and help the borrower.
Institutions must focus on leading indicators of problems e.g. increased use of overdraft,
seeking new credit lines, slow payment of trade creditors, late supply of information.
These tend to indicate a growing need for cash. Lenders who act only after being directly
affected e.g., past due payments, are not acting in the best interest of their institution.
Since the key objective in managing Problem Loans is to detect the problem early GBRW’s
initial focus is on Problem Loans and then on Non-Performing Loans (NPLs). Banks need to
see the signs of "cash crisis" at the borrower and take action.
A Problem Loan becomes a Non-Performing Loan on default and if that default is not
corrected within a set number of days, usually 45 days in developing economies.
RULE 2: DETECT PROBLEM
Factors that can result in a good loan turning into a bad loan can be
categorized into three broad groups:
External Causes: Included are factors outside the control of the company's
management and/or the lender. Examples include negative economic events such as
high interest rates, recession, technological advances making the company's products
obsolete, “Acts of God” such as floods and fire.
Internal Causes: Factors brought on by the company's management. Generally
attributed to management deficiencies such as lack of managerial, operational,
and/or financial controls; product deterioration; loss of market share; not keeping up
with the competition and fraud.
Lender Causes: Factors brought on by the lender. These causes generally include
improper loan structuring, an inadequate or excessive loan amount, failure to
adequately monitor a loan, improper statement analysis, insufficient collateral, poor
documentation, an inexperienced lender, and fraud.
CAUSES OF PROBLEM LOANS
It is far better if the lending department can work with the customer to resolve
the problem rather than the customer go into default and after 45 days be
transferred to the loan Workout Department.
The methodology for recovery will be similar but the Workout Department are
likely to be harsher “hatchet persons”. They are dedicated to getting back the
bank’s money as quickly as possible (and their bonus will depend upon the
resolution of the NPL).
The level of provisioning for a Problem Loan will be lower than for a NPL. If the
customer is still paying principal and interest, albeit on deferred terms .
A word of warning: it is natural for lending departments to extend the maturity
and reduce the margin of customers who are experiencing cash flow difficulties.
This can only happen once. If loans are continually restructured it just hides the
RULE 3: IT IS BETTER TO HAVE A
PROBLEM LOAN THAN A NPL
Are the people who made the loan the best people to collect it if it becomes a
Probably not as they will naturally be sympathetic to their customer and maybe
less concerned about the overall interests of the bank. However, if they cannot
resolve the issue of late payment by a customer within 45 days it should be
taken out of their hands
Need for an independent loan Workout Department
This would be part of the Risk Management Division which doesn’t report to
any Front Office Division.
Independent Restructuring Credit Committee
Is the committee that approved the loan the best place to approve its
restructuring? Probably not and it may have too many influences on its decision
making. Better to have a wholly objective and independent committee whose
decisions cannot be overturned by anybody in the bank.
RULE 4: TRANSFER OF
Similar Goal but Different Approaches: While the objectives of managing commercial
and retail Problem Loans are the same; i.e., obtaining Maximum Recovery in the
Shortest Possible Time, the approaches and business models used are different.
Retail defaults: Given the relative size of individual retail loans and the number and
diversity of the retail customer base, establishing a retail workout department consisting of
account officers responsible for recovering individual loans is not cost effective. Instead
the recommended business model emphasizes monitoring concentration risk and investing
in communication systems that automatically send past-due loan notices containing
escalating intensity, base on the length of payment default.
Corporate defaults: The potential impact of a credit loss associated with a commercial
customers is greater than that of a retail customer. Given the greater probability of loss
associated with commercial loans a larger investment in monitoring and managing (on a
customer by customer basis) is justified. For this reason financial institutions with
substantial commercial loan portfolios dedicate resources (financial and human) in
managing corporate Problem Loans and Non-Performing Loans.
RULE 5: MANAGING DIFFERENT
PROBLEM LOAN PORTFOLIOS
There is nothing more expensive than a problem loan.
It is not just the cost of carrying the Non Performing Loan, it is the
management time and effort, the expense of using lawyers and other
Put timelines into the methodology
After 90 days a Game Plan has to be presented to the Restructuring
Credit Committee. If after 180 days the NPL is still unresolved it has to
be resubmitted to the Restructuring Credit Committee and every 90
Avoid going to court
It will delay matters further, it will be expensive and you might not get
the result you want. This is a last resort.
RULE 6: SPEED IS OF THE ESSENCE
Security is never worth what you think it is
First you have to be sure that the collateral is protected and will not
deteriorate, this costs the bank money.
Then you have to be sure that you have legal title to the collateral and
are entitled to sell it (and this usually results in a few nasty surprises).
Then you have to get title and sell the collateral. All the buyers will know
that the bank is a forced seller and will under-bid.
If you add up all the costs, the collateral may only be worth 10% of what
you originally thought it was worth.
Selling the security is the action to be taken if all other avenues have
been explored and failed.
RULE 7: NEVER RELY ON SECURITY
Resolving commercial Problem Loans involves an
analysis of the borrower’s management, financial
statements and cash flow
Management Analysis: A thorough analysis of management must be
conducted after the problem has been detected; notwithstanding any
prior analysis that might have been performed. Assessing management
involves a review of:
General Management Capabilities;
Crisis Management Capabilities;
Management Integrity (are they honest?); and
Turnaround Management Capabilities.
PROBLEM LOANS – PART 1
Financial (Statement) Analysis: This attempts to evaluate, from a
financial perspective, the company's performance in the light of the
causes, viability of the core businesses, and the solvability of the
Problem Loan. The viability of a company’s core business is driven
Overall demand for the company’s product or service;
The company’s ability to generate sales in excess of its
The company’s ability to consistently generate positive
cash flow; and
The ability of the company to cut costs sufficiently to make
the business viable again.
PROBLEM LOANS – PART 2
Cash Flow Analysis
This analysis attempts to understand and evaluate the cash sources and
cash uses of the company; i.e., how the company generates cash and how
the company uses cash. This information is not apparent by an analysis of
the financial statements.
Cash Flow Analysis – Using the Cash Budget Model
Cash Budget model (next slide) is a simple yet effective tool. It is easy to
explain to the entrepreneur and easy for them to understand.
The Cash Budget model can be use to forecast and monitor a company’s
cash flow, as well as to understand variances in cash generated and cash
used by a borrower.
The Cash Budget can be prepared on a quarterly, monthlyor weekly basis.
PROBLEM LOANS – PART 3
CASH BUDGET MODEL Period 1 Period 2 Period 3 Period 4
Cash on Hand (beginning of
+ Cash Receipts
+ Total Cash Receipts
Cash Available (before cash paid
- Cash Paid Out
- Total Cash Paid Out
-/+ Cash Surplus (Deficit)
+ Borrowing (new loans)
- Loan Principal Payment (new
Total Principal Outstanding
- Interest Expense (new loans)
Cash On Hand (end of month)
CASH BUDGET MODEL
DECISION PROCESS STEPS 1 - 6
Make 100% provision
Liquidate the collateral
Bankruptcy of client
If the analysis indicates that a workout is in the best interests of the
lending institution, then the next step is to develop a “Game Plan.”
The Game Plan is developed for the benefit of the lender — not the
The first objective of the Game Plan is to obtain the maximum recovery
warranted by the situation, the secondary objective is to rehabilitate the
The other options that the available to the lender are:
Doing nothing; in other words just write off the loan 100%
Liquidating collateral (which will cost money and deliver less than
Petitioning for the borrower to be placed in (involuntary) bankruptcy. Let
the courts sort it out which at least means the bank doesn’t have to spend
any more money.
DEVELOPING THE GAME PLAN
Refinance the loan with another bank: If the lender has identified the problem early and
quietly enough, it may be possible that another lender (who wishes to increase loan
production) may make a loan that repays the original loan. In many ways the ideal solution.
Customers tolerance for resolving the problem: is the customer willing to work hand in
hand with the bank and take the necessary steps to put themselves on a viable business
footing, this usually means a significant reduction in operating costs including a cut in their
Back to the Cash Budget: the company will now be run, and monitored, according to the
Cash Budget prepared by the bank and accepted by the customer.
Restructure the loans to the bank: the bank will no doubt have to extend the period of its
loans and possibly reduce its margins to enable the Cash Budget to work. In some cases it
may have to write off part of the principal amount, known as a “haircut”.
Other lenders and creditors: the bank is unlikely to be the only creditor. Those creditors
may be unequally unhappy. Who gets paid and who is asked to take a “haircut”?
The Game Plan: a written agreement between the customer and the bank (and other
creditors) which sets out the steps and timetable to rehabilitate the business of the
DEVELOPING THE GAME PLAN
Should Your Institution Have a Workout Department?
Problem loans should be administered by experienced lenders who can provide objectivity.
Resolving problem loans involves highly specialized and time-consuming tasks, requiring skills
not possessed by many loan officers. Consequently, most banks benefit from the existence of a
specialised Workout Department .
Workout – A Special Department
Large banks or banks with a significant amount (number and/or size) of commercial loans
benefit from establishing an independent Workout Department containing specialists available
to handle problem loans with no prior relationship with the customer
Staffing the Workout Department involves engaging specialists (possibly including lawyers) and
lending bankers with good analytical and negotiation skills.
Establishing a Workout Department allows the original department to continue to function
normally without spending a huge amount of time trying to resolve problems. They can get on
with what they do best, marketing bank products to customers.
They are a profit centre as Problem Loans are transferred to them after provisions so any
recovery of the provision is their profit . Once the NPL has been restructured it is transferred
back to the lending division, quite often with an equity kicker as the bank needs to benefit from
all the cost of restructuring the borrower.
In the majority of cases a customer will have defaulted through no major fault of
their own. If the loan officer cannot resolve the position within 45 days responsibility
is transferred to the Workout Department.
The mandate of the Workout Department is to “Obtain maximum recovery in the
shortest possible time”. This makes them a “hatchet person” with a very different
relationship with the customer.
This means that the existing working relationship and goodwill of the client is usually
lost (unless the Workout Department have a real skill in building a Game Plan to
restructure the business of the customer).
The Restructuring Credit Committee should have the flexibility to decide what is in
the best interests of the bank and maintain the relationship with the lending
It may also be that the number of Non Performing Loans is such that the Loan
Workout Department cannot handle them all.
NOT QUITE BLACK AND WHITE
GBRW can review, assess and recommend enhancements to the system of
Lending Authorities in the bank.
Written Credit Policies are very important and GBRW would be happy to review
or indeed draft new policies and procedures
A Risk Rating System is a valuable tool and needed in every bank
GBRW can draft a charter for the Loan Workout Department and the
Restructuring Credit Committee
Training and assistance with the development of templates of the Cash Budget
Model and the Game Plan
Mentoring and training of the staff of the Loan Workout Department by working
with them on individual NPLs
HOW CAN GBRW SUPPORT IN
MANAGING PROBLEM LOANS?
Successfully managing Problem Loans and NPLs involves strengthening
key aspects of the bank’s lending procedures and developing a
standardised recovery methodology.
A bank with limited experience in effectively managing Problem Loans
and NPLs should develop or acquire the specialized expertise needed to
administer the problem loans and NPLs.
GBRW would welcome the opportunity to better understand your
interests and/or needs relating to the management of Problem Loans
and NPLs, as well as to discuss in greater detail any of the services
presented within this document.
CONTACT DETAILS AND FURTHER
You can find out more about GBRW Consulting by visiting
our website on: http://www.gbrw.com
Visit our LinkedIn profiles and connect at:
Email us at firstname.lastname@example.org